Category Archives: Monetary Economics

Amar Bhide on the Fed

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He writes,

Instead of casting about for a new maestro, we need to return the Fed to dullness and its chairman to obscurity.

It is interesting that there is such a strong folk-macroeconomics belief that the economy will perform well if and only if there is a wise Fed Chairman. My current reading, Big Gods, is about the cultural advantages of religion. One of the advantages that the author overlooks is that people who put their faith in a divine being are less likely to deify humans.

Bhide writes,

Before the crisis the Fed seemingly lost all capacity for the painstaking, boots-on-the-ground supervision of the banks under its purview. And, effective or not, top-down monetary interventions remain attractive to the Fed’s top brass. Running what amounts to a hedge fund on steroids is more glamorous and exciting than managing a regulatory bureaucracy. Perhaps the most important qualification for the next Fed leader is one all too rare in Washington: humility.

During the Great Moderation, macroeconomists took the view that the details of finance do not matter. If the Fed sets the Fed Funds rate properly, it can achieve any macroeconomic objective. Scott Sumner still speaks for that view.

Bhide’s view is the opposite. The details of finance matter a lot, and the Fed’s monetary policy tools are not reliable. I am inclined to agree with Bhide.

Amar Bhide and Edmund Phelps on the Fed

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Their op-ed is a grab bag. For example,

It is doubtful, though, that quantitative easing boosted either wealth or confidence. The late University of Chicago economist Lloyd Metzler argued persuasively years ago that a central-bank purchase, in putting the price level onto a higher path, soon lowers the real value of household wealth—by roughly the amount of the purchase, in his analysis. (People swap bonds for money, then inflation occurs, until the real value of money holdings is back to where it was.)

What I think this refers to is the idea that when the government prints money, it collects seignorage, also known as the “inflation tax.” The implication is that quantitative easing amounts to nothing other than a tax increase.

Later, they write,

Households have maintained their strong propensity to consume, persuaded that their retirement incomes will be topped up with entitlements. But consumer-goods production—giant machines needing only a guard and a dog, as some wag put it—is generally not labor-intensive enough to provide high employment at normal wages. A central bank’s monetary policy, no matter how ambitious, cannot solve this structural problem.

In my PSST words, the Fed cannot create patterns of sustainable specialization and trade.

Still later, they write,

What we do need from the Fed is reform of the ways banks are regulated and supervised. Tough, on-the-ground examination of individual banks not only helps keep them solvent, such scrutiny can also prevent out-of-control money growth without suppressing productive lending. Similarly, rules that discourage banks from relying on yield-chasing hot money will limit the runs and panics the Fed has to fight.

This is a bit like my argument for principles-based regulation. The problem with letter-of-the-law regulations, like risk-based capital, is that they set the regulator up to be gamed. You invite financial wizards to come up with ways to dress up high-risk portfolios in low-risk clothing. Principles-based regulation, along with “on-the-ground examination,” means that you do not just sit back and watch helplessly while the financial wizards run circles around you.

Rules vs. Discretion

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Scott Sumner writes,

I’m all for a rules-based approach to policy. But unfortunately Taylor fails to make his case. You’d think a fan of rules-based policy would provide a razor sharp critique of Fed policy, but Taylor’s critique is anything but clear

Scott Sumner’s rallying cry is “Target the Forecast!” (for nominal GDP) and John Taylor’s rallying cry is “Follow the Taylor Rule!”

Some remarks:

1. I think I saw the clash between Sumner and Taylor coming even before Sumner did.

2. “Target the Forecast!” is, in a generic sense, what the Fed has been doing since the 1960s. The FOMC discussions revolve around forecasts. Fed staff scrutinize data closely in order to divine what it means for the forecast. Alan Greenspan was an intense and promiscuous data-scrutinizer. Taylor would argue that, until late in his term, Greenspan’s target-the-forecast approach happened to line up with the Taylor rule.

3. What is the result? As Ed Leamer puts it in chapter 15 of Macroeconomic Patterns and Stories,

On the basis of circumstantial evidence, the Federal Reserve Board, by raising rates late in expansions, can take some blame for almost all our recessions.

Below is circumstantial evidence of the sort he describes. See how large moves in the Fed Funds rate tend to lead large moves in the unemployment rate.

4. Leamer also says,

With all these patterns, it is a mystery* whether monetary policy can be said to cause anything or merely reacts to things that would have occurred anyway. But if I felt the need, I could suppress the doubt and tell with confidence the following story.

[Expansions start out with mild inflation. Then price pressures build as the expansion matures] But the Fed fiddles as inflation smolders. The ever-so-gradual increase in inflation is not enough to get the Fed to respond, but like a small brush fire, inflation soon enough gets out of control…By the time the data are in, and the Fed rate-setting committee has deliberated enough to make absolutely sure that it is time to make a change in monetary policy, inflation is burning fiercely and it takes a heavy spray of higher interest rates to put the fire out. That creates an inverted yield curve, a credit crunch** for housing, and an unpleasant recession. Oh, Oh, we’re sorry, say the Fed Governors, who knock down interest rates to try to get housing and the rest of the economy back on their feet.

5. From this historical perspective “target the forecast” is what got us where we are today. Sure, it looks like a great idea now, when we think that the expansion is still not mature and price pressures are still nowhere to be seen. But eventually “target the forecast” will once again result in a failure to change policy in time. We will continue to experience needless, Fed-induced cyclical behavior unless the Fed is lashed to a rule.

6. You might characterize my beliefs as:

Probability that “target the forecast” (using some market prediction for nominal GDP) would stabilize the economy = .15

Probability that “stick to a rule” would stabilize the economy = .10

Probability that monetary policy “merely reacts to what would have occurred anyway” = .75

*The “mystery” arises in part because the Fed only controls the short-term nominal interest rate, and it is the long-term real interest rate that most plausibly drives spending. In chapter 5, Leamer writes,

the interest-rate on the 10-year has a life of its own, sometimes moving with the 3-month rate, but not always. That should make one wonder how much impact the Fed has on the longer-term rates and also wonder how much it matters.

In chapter 15 he says that

long-term interest rates were generally elevating at the ends [of economic expansions since 1960]. Maybe that is what killed off housing. Maybe that would have occurred even if the Fed had not taken action.

**Leamer was writing prior to 2008, when a different sort of credit crunch arose. I will discuss the Leamer credit-crunch model in a subsequent post.

How to Interpret Asset Market Prices?

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Jeremy Stein says (in my words) “Don’t try.” His words are

fundamentals only explain a small part of the variation in the prices of assets such as equities, long-term Treasury securities, and corporate bonds. The bulk of the variation comes from what finance academics call “changes in discount rates,” which is a fancy way of saying the non-fundamental stuff that we don’t understand very well–and which can include changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of internal market dynamics.

If true (and I believe it is), this is a very important statement. It implies that events are in the saddle and ride the Fed. Not the other way around.

Pointer from “G.I.” of The Economist blog, via Mark Thoma.

Julio Rotemberg’s Theory of Fed Behavior

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Simple, but brilliant.

This paper focuses on a particular force that may help account for the qualitative changes in monetary policy across these periods. This force is the tendency of the Fed to act as if it were penitent when critics successfully argue that “bad outcomes” are a product of Fed “mistakes.” The description of past policy as having involved mistakes is a staple in the literature discussing Federal Reserve actions.1 Critics who seek to blame the Fed for bad outcomes typically go beyond saying that a particular policy move was unwise. Rather, they tend to argue that a particular pattern of Fed behavior is responsible for a series of unwise policy moves, and it is this pattern that they paint as being mistaken. The Fed then tends to become averse to this, now successfully vilified, pattern of behavior.

I think that all organizations act this way. When something bad happens, the organization goes overboard to make sure that it does not happen again. This may or not be constructive, given all of the potential bad things that might happen. Fits in with “fighting the last war” syndrome.

From a conference on the Fed’s 100th anniversary. Other papers here, and also a speech from Ben Bernanke.

Sumner vs. Williams

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John Williams writes,

The intuition for policy attenuation is that uncertainty about the effects of policy creates ex post policy errors that cause economic outcomes to differ from the policymaker’s intentions. The magnitude of the policy error is multiplicative in the policy action; that is, the larger the action, the greater the expected squared error. Therefore, the expected size of the policy error is affected by the size of the policy action, creating a bias toward muted policy actions.

Think of the shower-tuning analogy. Suppose the water is too cold. If you know exactly how the water temperature will change as you move the knob, you turn it quickly. If you are not sure how much the water temperature will change for a given amount of turning, you turn the knob more slowly, to avoid getting scalded.

Scott Sumner comments,

Williams misses the bigger picture, those “demand shocks” were contractionary Fed policy. More specifically they were caused by the failure of the Fed to do NGDP level targeting. The Fed set the wrong target in each year, and this caused the vast majority of the “demand shocks”. With a policy of NGDPLT along a five percent trend line, the recession would have been far milder, with unemployment probably peaking at 6 to 7 percent.

A digression for people of the concrete steppes. No, it wasn’t just “errors of omission”. After growing at 5 percent per year during the Great Moderation, the Fed brought growth in the base to a sudden halt from July 2007 to April 2008. Yet the Fed saw itself as a valiant knight fighting off recession by cutting the Fed funds rate, as if interest rates were a reliable measure of the stance of monetary policy. They aren’t. But even if they were, the Fed drove real interest rates sharply higher in the second half of 2008, a time when they weren’t at the zero bound. So there were plenty of affirmative actions taken by the Fed to drive us into a deep slump. BTW, the base isn’t a reliable indicator either, only NGDP expectations count.

Sumner thinks that the Fed ignored the temperature of the water and just stared at the knob.

Quackroeconomics

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I’m back to that title. Comments welcome on this idea for how it might open:

In discussions of macroeconomic policy in Washington and in the press, these four propositions are taken as given:

(S) Spending is what drives the economy. Spending creates jobs, and jobs create spending. When unemployment is high, the problem is too little spending.

(M) Monetary policy must steer the economy carefully between overheating and slumping. Doing so requires high levels of skill and intellectual resources.

(F) Fiscal policy is just as important. When there is unemployment, monetary policy cannot do the job alone, because the Federal Reserve also has to keep an eye on inflation. So the Federal government must engage in deficit spending to stimulate the economy.

(C) Computer models are essential tools that enable economists to forecast the economy and assess the impact of alternative economic policies. Using computer models, the Congressional Budget Office is able to score the number of jobs a particular policy will add to or subtract from the economy.

These four propositions are what I term quack macroeconomics, or quackroeconomics for short. Like quack medicine, quackroeconomics is unproven, unreliable, inconsistent with the views of leading researchers in the field, and possibly dangerous.

Until now, however, there has not been a book that confronted quackroeconomics head on. Other economists seem reluctant to do so. Instead, they prefer to accommodate it.

Academic economists who would never teach it to students nonetheless write op-eds that employ quackroeconomics. When they come to Washington as economic advisers, they adopt quackroeconomics with alacrity.

The authors of undergraduate textbooks provide theoretical analysis that, if properly understood, discredits quackroeconomics, but such conclusions are never spelled out. As a result, students come away from class with quackroeconomic intuition rather than an understanding of the analytical models.

In graduate school, professors discard what students learn as undergraduates and teach something else entirely. The advanced material is even further removed from quackroeconomics, but by this point it does not matter. Most of these students will never again think seriously about macroeconomics as a whole. Those who are troubled by the discrepancies between quackroeconomic intuition and what is taught in graduate courses are those who are least likely to stick with macroeconomics. Instead, they will go into another economic sub-field, such as environmental economics, economic development, or industrial organization. Those who pursue macro will do so because they enjoy the sort of mathematical puzzle-solving that nowadays leads to a tenured professorship in macroeconomics.

I worded M, F, and C carefully so that just about every economist would disagree with them. In fact, my guess is that many would object that I am attacking a straw man. I believe, however, that this is not a straw man when it comes to economic journalism. If readers spot articles in the press that pertain to this issue, please leave a comment (you do not have to go back and find this post–any post on the blog will do)

The Fed, Interest Rates, and Inflation

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Scott Sumner points to David Glasner, who writes,

So, if the ability of the central bank to use its power over the nominal rate to control the real rate of interest is as limited as the conventional interpretation of the Fisher equation suggests, here’s my question: When critics of monetary stimulus accuse the Fed of rigging interest rates, using the Fed’s power to keep interest rates “artificially low,” taking bread out of the mouths of widows, orphans and millionaires, what exactly are they talking about?

I am not the person to whom this question is addressed. Anyway, read his whole post. Another excerpt:

Either the equilibrium real interest rate has been falling since 2009, or the equilibrium real interest rate fell before 2009, but nominal rates adjusted slowly to the reduced real rate.

In a number of posts, I have been saying that the closer you look at mainstream macroeconomics, the more incoherent it becomes. The issue of nominal and real interest rates is a case in point. Suppose you believe the following:

1. The Fed controls the short-term nominal interest rate, or at least a short-term nominal rate.
2. The long-term real interest rate is fixed by market conditions.
3. When the Fed lowers its interest rate, expected inflation goes up.

If you believe those three things, then when the Fed lowers the short-term rate,

(4) the long-term nominal rate has to go up.

Essentially everyone believes (1) and (3). But hardly anyone believes (4)*, so clearly (2) is what economists are least attached to. At least implicitly, macroeconomists believe that when the Fed lowers the short-term nominal interest rate, the long-term real rate goes down as well.

(*I tend to think of Scott Sumner as having coherent views, with which I disagree. Accordingly, I think of him as believing (4). What taking this view means, though, is that relative to other macroeconomists, one needs higher expected inflation to do most of the work in driving up aggregate demand. Expecting more inflation, people attempt to unload their money holdings onto goods. Since you don’t get a drop in real interest rates, it seems to me that the only reason for stock prices to go up is if you think that investors like it when people unload money and go into goods.)

My own idiosyncratic view is that I prefer to hold onto (2) and let go of (3). I would explain the drop in long-term real interest rates since 2009 by appealing to a drop in demand for investment relative to the supply of (savings minus government deficits). I assume this is worldwide, not just limited to the U.S. I would not credit the Fed with any of it. I am not sure that I would label it as an “equilibrium” phenomenon, because I think that bond buyers were not entirely rational. I know that for a while I had a really big exposure to TIPS, but as they went up in value (because real rates were declining), I thought to myself, “Hmm. Capital gains on a ‘risk-free’ asset. How nice. But if they can go up, can they not also go down?” So when the recent bond market sell-off hit, I had much less exposure (not that what I switched into worked out any better).

I view QE as the Fed swapping short-term debt (interest-bearing reserves) for long-term debt. The Fed gets to ride the yield curve in exchange for taking on huge market risk in its portfolio. This might reduce long-term real rates a bit, although I have always leaned toward skepticism on that score.

I lean to the view that inflation is a fiscal phenomenon. I have never heard of a country that cranked up the printing presses while running a balanced budget. I have never heard of a country running hyperinflation that was not fiscally profligate. There might be instances of countries running deficits of 100 percent of GDP or more who were able to return to balance without undertaking a formal default or going through a period of high inflation, but I cannot think of any.

Taking the view that inflation is a fiscal phenomenon does not help with short-term inflation predictions. For example, in the U.S. these days, we don’t know exactly when or how the fiscal imbalance will be resolved.

They will tear up my libertarian union card for saying this, but I do not believe that the Fed’s buying and selling of securities are a big distortionary factor in the financial markets. I think that the Fed could get us above the 0-2 percent inflation rate if it really wanted to, and maybe it should try, in case the AS-AD model turns out to be correct. But if you believe PSST, it could turn out that higher inflation would produce no increase in employment, and it might even make it worse.

A Question Comes Back to Haunt Me

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Simon Wren-Lewis asks,

Do budget deficits cause inflation? Let me be a little more specific: does raising the level of debt and keeping it there when the economy is at full employment raise the price level? The conventional answer is: not if the central bank controls inflation. Sometimes economists say the same thing in a different way: not if the debt is not monetised.

Pointer from Nick Rowe.

I was asked this question in 1975 on an Honors Exam given by William Poole (Swarthmore used outside examiners. Poole was then at Brown, I believe.) I said that if the government tried to use deficit spending to boost an economy that was already at full employment, this would cause ever-increasing inflation. “Wrong. I didn’t go to the University of Chicago for nothing,” Poole harrumphed. “If the central bank doesn’t increase the rate of money growth, inflation will not go up.”

A few years later, Sargent and Wallace wrote a paper that said that, in effect, that I was right, at least in a rational-expectations world. The reason is that when the government runs such deficits, it creates the expectation that they will be monetized, and because people anticipate that, prices start to rise.

In terms of the way Wren-Lewis asks the question, it seems to me that a textbook answer would be that it depends on the central bank’s reaction function. If it uses a Sumnerian NGDP target, then you get 100 percent crowding out of private investment, presumably because the long-term real interest rate goes up. With other reaction functions, you get some monetization of the debt. If the reaction function is to fix the money supply, then it is plausible that velocity goes up a bit, which gives you more inflation.

Truth be told, I think the sort of monetarist analysis in the preceding paragraph or that Rowe is reaching for is bunk. I am more inclined to think of money in financial terms, as just one of many forms of government debt. My thinking is that small changes in central bank policies get overwhelmed by other factors in financial markets and in the economy. To cause a shift in the inflation regime, the central bank has to be really determined.

Suppose we ask an opposite sort of question. What happens if the government is balancing its budget and the central bank wants to go on an inflation binge? On the one hand, it is certainly true that the central bank can find assets to buy (old government debt, private debt, foreign currency), so it ought to be able to cause inflation. On the other hand, has this ever happened? In practice, is high inflation always a fiscal phenomenon?

James Hamilton on the Rise in Interest Rates

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He writes,

The yield on 10-year U.S. Treasuries has jumped 50 basis points since the start of May, leading some to speculate that the market is already starting to price in anticipation of an end to the Fed’s bond-buying program. There may be some truth to that, but it’s only part of the story.

…It’s worth emphasizing that the recent rise in interest rates has been a global phenomenon, not just something seen in the United States.

It would be nice if you could attribute the rise in interest rates to a rise in expected growth in nominal GDP. However, my portfolio, which should benefit from an increase in expected inflation, instead was hurt by the rise in rates. I infer that there has been an increase in the expected real rate of interest. It’s not clear where that is coming from, other than the fact that real rates cannot stay absurdly low forever.

Of course, the rise in real rates could indicate that investors have become optimists like Tyler Cowen.